5/25/2021 Introduction to Financial Modelling – Varsity by Zerodha

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Module 13 Integrated Financial Modelling → Chapter 1

Introduction to Financial Modelling

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1. 1 Introduction to Financial Modelling

1.1 – Unusual approach

We are all living in a very uncertain and unprecedented time. Covid 2nd wave has been brutally devastating
and has caused a lot of pain and misery to humanity. I hope you are your family are staying safe. Please
double mask if you really have to step out. I hope humanity does not have to face this situation ever again,
and we get out of this situation as quickly as possible.

Let me start this module on Financial Modelling with an apology. I know this module was due for a while
now. I know, I’ve taken a lot of time to get started on this. There were multiple reasons for the delay, but
that’s all behind now. Here we are, all set. I’m super excited to deliver this module, and I hope you are
excited as well

But there are a few things to note before we get started –

Financial modelling as a subject is taught either in the classroom or in a video format. There is a reason for
this – while teaching this subject, at any given point, we tend to open up multiple threads and then tie it all
together in the end. So in a sense, there are hops, jumps, crisscrossing, and a bit of number juggling. Given
the nature of this subject, it makes sense to teach this online or via a physical classroom setup.

Think of it as producing a movie. I’m sure you understand that a movie is not shot scene after scene in a
sequential manner. Different scenes are shot, songs are recorded, action scenes are shot, edited, and then
patched together and eventually made to look like the entire movie was show scene after scene.

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In a sense, financial modelling is very similar. You will understand this better as we dig deeper.

I don’t know if financial modelling is taught in the classic article format. I could make a huge mistake
attempting this task, but I think it is worth the shot.

As I just hinted above, the learning won’t be sequential. We will have multiple threads open; numbers will
crisscross and move from one sheet to another, adding to the non-sequential learning format. But that’s the
way this will go, so please be prepared for it.

As we progress through, you will realise that Financial Modelling is more of an art form than financial
science. We throw in a ton of assumptions while building any financial model. The assumptions may vary
from person to person based on the individual’s experience.

However, the good part is that the model we create will very easily accommodate changes and updates; this
flexibility makes financial modelling a beautiful endeavour.

1.2 – What are you learning and why?

Perhaps an essential question – what is ‘Integrated Financial Modelling’, and why do we need to learn this?

Think about a typical company; as you can imagine, the company can have several moving parts. For
example, a manufacturing company can have a team procuring raw materials, workforce to manufacture
goods, admin team, finance team, regulators, compliance, marketing, supply chain, distribution, R&D, and
whatnot.

Given the enormity, how do you break a company down into smaller parts and gain meaningful insights into
its functioning? How do we gauge its efficiency?

Well, this is where financial modelling comes into play. Eventually, whatever the company does, it all boils
down to numbers and metrics.

For example, successful operations lead to revenue generation, successful cost management leads to
operating profits. Good financial practice leads to manageable debt levels; good supply chain management
leads to better inventory management. Good dividend policy strikes a balance between a company’s growth
and shareholder value. So on and so forth.

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So the approach we take here is that if we can systematically analyze the numbers presented in the financial
statements, perhaps it opens up a window to understand the company better.

When I talk about understanding financial statements, I’m talking about getting into granular details; we go
line by line. Many often assume that a series of simple financial ratio analysis results in great insights into
the company. Yes, to some extent, it does, but we can do a lot more to better understand the company.

Better understanding leads us to a better insightful investment decision.

Think about Financial modelling as a systematic way to understand the company. Here is what the name,
‘Integrated Financial Modelling’, means –

Financial = Indicates that we are working with the company’s financial statements

Modelling = Indicates that we are laying down a company’s financials systematically, connecting these
financial statements and subjecting the same to a bunch of equations. The entire thing tied together is called a
model, a model with specific input (financial statements) and a specific output (valuations).

Integrated = Implies that all the numbers are interconnected, and no part of the financial model is isolated.
You will understand this better as we progress through building the financial model.

The end objective of any financial model is to help you build a perspective of valuation. The final output of
the financial models is the company’s share price after factoring in everything that matters. You take the
share price from the model, compare the share price against the market share price, and figure if the stock is
fairly valued, undervalued, or overvalued.

The ultimate satisfaction is when you know that the stock is undervalued and available for a throwaway price
in the market, trust me on that

1.3 – Tools of the craft

Let me break the ‘not so good news’ first – to learn, build, and benefit from a financial model; it is
mandatory to have some background knowledge about the following –

How to read an annual report

How to read the financial statements of the company – Balance Sheet, P&L, Cash Flow
It would be best if you were comfortable working with MS Excel or any other software similar
to MS Excel

The good part is that you can learn how to read the annual report, Balance sheet, P&L, and Cash flow in the
fundamental analysis module.

Unfortunately, we don’t have a module on MS Excel, so please try and self-study MS Excel. If you are
uncomfortable with any of the three topics mentioned above, please stop right now and learn these things
before learning Financial Modelling.

Please do note, when I say you need to know how to read financial statements, I only mean that you need to
know this from a user’s perspective. As long as you know the basics, that is good enough.

The same goes with Excel. It would help if you were good enough with essential functions and formats. I
don’t expect you to have the knowledge required to build a complicated dashboard on excel.

The good news is that when I decided to learn Financial Modelling, I had no clue about the three things I
mentioned above. I had to learn these things first and then get back to financial modelling. If a person like
me can do this, then I’m confident anyone can.

By the way, financial modelling as a concept can be applied to any part of market finance, be it investing or
derivatives trading. Financial modelling is nothing but a structured way of thinking through a complex
problem; some even call this ‘Design thinking’ of sorts.
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If you are a regular reader of Varsity, we have dabbled with Financial Modelling in the module related to
Risk management and in the Trading systems module. It’s just that we never called it ‘Financial Modelling’.

This module, however, will be focused on Fundamentals and Financial Modelling for investments.

1.4 – The steps involved

At this point, I’d like to share with you a brief overview of the steps involved in creating an integrated
financial model. These steps only give you a sense of direction. We will dig deeper into each of these steps as
we proceed.

These are the steps involved in building a financial model –

Set up a layout – Perhaps the most crucial aspect of financial modelling. I foresee myself stressing on this
several times throughout this module, so bear with me. A typical Financial model will have multiple excel
sheets within a single workbook. We need to ensure our Excel workbook is appropriately indexed and
formatted and the format stays consistent across the entire model.

For example, if I’m dealing with 2018 data in column ‘E’ of my excel sheet, I’ll ensure that column E across
all the other sheets will always deal with 2018 data. Or here is another example of the layout, column A and
B will be shrunk to ensure easy indexation across all the sheets.

At this point, this may come across as a bunch of vague statements, but you will appreciate these points as
we progress along.

Historical Data – A rather painful task, but this need to be done. We need to download the Annual report of
the company we are dealing with, preferably for the last five years. We need to extract the balance sheet and
P&L data from the annual report and input this in our excel sheet. Of course, we will be dealing with
consolidated numbers here and not standalone data.

Most importantly, please use the annual report as your primary data source and not any other 3rd party data
vendors.

Assumption Sheet – Remember I spoke about financial modelling as an art form rather than financial
science? Well, we create an assumption sheet and dump all our assumptions in one sheet here. We assume
things about the company should be close to reality; the further we go from reality, the more distorted our
model gets. Let me give you an example.

Suppose a company’s revenue is growing at 7% year on year for the last five years; what do you think will be
the growth rate for the 6th year? If we have to assume something, it has to be in the region of 7%, unless you
foresee a significant change. Anything higher or lower will distort the P&L from reality.

Asset and other schedules –Throughout the model, we create something called a ‘schedule’. We create a
schedule with oversized line items. For example, the asset schedule deals with plants, machinery, and all the
company’s fixed assets. We lay down the numbers in a systematic way and deal with them. For example, we
extract the gross block number, depreciation, netblock, and even the CAPEX figures in the asset schedule.

So a single schedule gives us insights into multiple aspects of the company.

Like the asset schedule, we create other schedules such as – reserves schedule and the debt schedule.

Projections – Once the assumptions are complete and the schedules, we project the balance sheet and P&L
for either 3 or 5 years forward. This is one of the crucial steps while building the model.

Cashflow derivation – Again, a very crucial step in financial modelling. In this step, we derive the cash
flow statement using the P&L and Balance sheet data, called the ‘indirect method’, of cash flow preparation.
Note, unlike the Balance sheet and P&L data, historical data of cash flow is not extracted from the annual

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report but instead derived. This step can be tricky; it sometimes works and sometimes does not work due to
its complexity.

Hence we will also look at alternatives here.

Ratios – Once all the data is in place, we can quickly draw up ratios and charts for our model. The ratio
sheet will include things like liquidity, solvency, profitability ratios etc.

Valuations – In the valuation sheet, we deploy the discounted cash flow method of valuation and finally
value the company. Think of this step as including a model within a model. Of course, we will have
sufficient checks and balances in places to ensure we are not going way off the mark, and even if we do, the
sensitivity tables that we develop should help us get back on track.

These are roughly the steps involved in developing a full-fledged integrated financial model. While it makes
it seem simple, trust me, it is not.

I’m excited to dig deeper. I hope you are too, so buckle up for the ride

Key takeaways from this chapter

A financial model takes in inputs in the form of financial statements and gives us an output
mainly in terms of valuations
Financial modelling involves a non-sequential learning path
Multiple discussion threads open up while building a financial model
Basic working knowledge of MS Excel, Balance Sheet, P&L, cashflow is mandatory before
venturing into financial modelling
There are 7-8 steps to follow while building a financial model
The model that we build has to be flexible to accommodate changes and updates.

112 comments
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1. Sundeep says:
May 17, 2021 at 5:52 pm

Sir finally the module is here and I am super excited as well.

I am starting to think this might be your most personal module yet.
Anyways sir. Looking forward to more modules soon. \

Thank you.

Reply

Karthik Rangappa says:

May 17, 2021 at 9:38 pm

All modules are personal to me, Sundeep

Reply

2. Vishal puri says:

May 17, 2021 at 6:16 pm

I like this varsity initiative it’s much more usefull then expensive financial books and easy to
understand

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Reply

Karthik Rangappa says:

May 17, 2021 at 9:45 pm

Good luck and happy reading, Vishal

Reply

3. Yerra V S N Sai Sudheer says:

May 17, 2021 at 6:21 pm

Game on!!!!

Reply

Karthik Rangappa says:

May 17, 2021 at 9:45 pm

Yes Sir!

Reply

4. kinshuk jain says:

May 17, 2021 at 7:10 pm

Please make a module on market cycles and algorithmic trading.

Reply

5. Sidharth says:
May 17, 2021 at 7:20 pm

Excited to learn this. Hopefully this will make me a better investor.

Reply

Karthik Rangappa says:

May 17, 2021 at 9:45 pm

Hopefully it should help

Reply

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2. Technical Analysis

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3. Fundamental Analysis

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13. Integrated Financial Modelling

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